The Housing Chronicles Blog: Why Hillary Clinton's mortgage rescue plan could backfire

Wednesday, February 6, 2008

Why Hillary Clinton's mortgage rescue plan could backfire

Besides being very expensive, Hillary Clinton's proposal to freeze rates on adjustable mortgages about to re-set could indefinitely cast a pall over the entire mortgage market. An article from The New Republic lays it out:

The plan is essentially to repudiate, revoke, or compel the revision of millions of contracts. There are approximately eleven million mortgages in America with adjustable rates, with a total value of more than $2 trillion dollars--a lot of money, even by Washington standards. Even restricting the plan to the 3.4 million subprime ARM loans (roughly $700 billion) would require an intervention of massive scale.

An even more serious problem with Hillary's proposal is the nature of the solution it proposes. When someone takes out a loan with a low, so-called "teaser rate" that is scheduled to increase in a couple years, the investors who put up the money for that loan are counting on at least some of the borrowers to hold on to their mortgage long enough to start paying the higher rates. Without the promise of this increase, the initial rate would have had to be much higher. As economists like to say, there is no such thing as a free lunch.

What would happen if scheduled rate increases were halted? Although it might make some borrowers happy, such a freeze could potentially poison the mortgage market and quickly exacerbate the slump in housing prices. If lenders and investors do not receive the interest payments they expected, they will be wary going forward. Should they avoid providing funds for adjustable rate mortgages, since the government would have just proven that the terms can be changed if difficulty arises? Should they avoid all mortgages, since the government now seems to prioritize short-term concerns for borrowers? Maybe they should avoid lending in the United States altogether?

Such a policy would clearly send a dangerous message far beyond our borders. Two trillion dollars of U.S. national debt is held by foreign governments. Interest rates on this debt are low in part because foreigners trust the U.S. to pay back its loans as promised. The rates would surely be higher if its holders thought the U.S. could renege on its promises to pay. But this is precisely the expectation America would encourage by unilaterally changing the terms on $2 trillion in mortgages held by investors around the world...

An accurate assessment of the current mortgage problem would probably reveal no more than 700,000 loans with distressed borrowers. Why, then, would the U.S. government rewrite eleven million loans, or even all 3.4 million subprime mortgages? Any intervention should be targeted at the borrowers who are truly in trouble, especially those who were likely duped by unscrupulous mortgage lenders. The numbers suggest these victims are disproportionately poor, young, and African American. Looking forward, the government needs to take steps to make this market more transparent and make it easier for borrowers to make good choices. But it would be irresponsible to do this by ruling millions of legal contracts null and void.

Senator Clinton's policy amounts to a command-and-control approach to economic policy in which the government announces prices and tells suppliers what to produce. Undertaking such an intervention can only raise interest rates on mortgages (and maybe other interest rates as well) as markets attempt to incorporate risk premiums to cope with possible future interventions. Promising the American people that you can fix things by just lowering their interest rates is dishonest, a fairy tale that won't come true.

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